Happening in China - late January 2016

Capital flows

Opening up the capital account facilitated Japan’s integration into global trade and finance, and also helped in developing and deepening domestic financial markets. But it also made exchange rate management harder. An open capital account without a flexible, market-determined exchange rate complicates monetary policy.

In an ideal world, the correct sequence is clear — fix financial markets, free up the exchange rate, then open up the capital account. In a less than ideal world, an opportunistic approach to reforms may be the best available option.

The PBoC wisely used the goal of elevating the renminbi into the IMF’s basket of reserve currencies by the end of 2015 as a tool for opening up the capital account, freeing up the exchange rate and undertaking a number of financial sector reforms.

Prasad's recommendations to boost growth are: use fiscal policy, commit to more reforms, and design a "communications strategy that makes clear what the government’s short-term and long-term plans are for currency market and other financial sector reforms".

The People’s Bank of China (PBOC) faces a dilemma. After nearly a decade of trying to curb expectations of continued currency appreciation (spurred by China’s current- and capital-account surpluses), it finally succeeded in the first quarter of 2014, when its forceful market intervention drove down the renminbi’s exchange rate to discourage carry trades. Now, however, the PBOC is facing an even more difficult challenge, as seemingly irreversible depreciation expectations undermine economic stability at a moment when China can least afford additional uncertainty.

“A fixed exchange rate looks stable, but it hides accumulated problems,” People’s Bank of China Vice Gov. Yi Gang said in August in explaining why the bank had let the yuan drop and its value would henceforth be “market-determined.”

In options markets, the yuan’s “implied volatility,” a measure of how much it costs to protect against big moves, has risen sharply in recent months, nearing levels more typical of the yen and euro.

There are signs a more unpredictable yuan is having the desired effect. Mr. Piron says a main driver of capital outflows from China has been Chinese companies paying off their foreign-currency debt.

The near-disappearance of currency crashes in the 2004-2014 period largely reflect low and stable international interest rates and large capital flows to emerging markets, coupled with a commodity price boom and (mostly) healthy growth rates in countries that escaped the global financial crisis. In effect, many countries’ main concern during those years was avoiding sustained currency appreciation against the US dollar and the currencies of other trade partners.

That changed in 2014, when deteriorating global conditions revived the currency crash en masse. Since then, nearly half of the sample of 179 countries ... have experienced annual depreciations in excess of 15%.

In the face of almost $700bn capital flight from China in 2015 as Chinese companies scrambled to pay off overseas loans amid a weakening renminbi, capital controls could reduce the downward pressure on the renminbi, allowing greater consumption in China to help rebalance the economy without a renewed surge in price-sensitive exports. Asked if she agreed with Mr Kuroda’s suggestion, Ms Lagarde dodged the question, but said: “I think the massive use of reserves is not a good idea”.

FT: Capital flight from China worse than thought: "Over-invoicing for exports, cash transactions and other such flows recorded as “errors and omissions” accounted for $216bn of the $676bn in China’s net outflows in 2015, according to the IIF."

China will never succeed if it does not bring its financial reforms into closer sync with its rebalancing strategy for the real economy. Capital-market reforms – especially the development of more robust equity and bond markets to augment a long dominant bank-centric system of credit intermediation – are critical to this objective. Yet in the aftermath of the stock-market bubble, the equity-funding alternative is all but dead for the foreseeable future. For that reason alone, China’s recent financial-sector setbacks are especially disappointing.